How To Fix The Collapsing Ceiling In Used Cars

July 25, 2018

If you had the unfortunate experience of living in a house where the ceiling was slowly collapsing, you’d face one of two corrective choices.

First, you could prop up the ceiling. I imagine this would involve using 4’ by 4’ posts, or maybe a metal beam, in the spots that sag the most.

Second, you could lower the floor. I’m not an architect or a contractor, but I suspect both would think that, while doable, a lower floor is only a costly, temporary fix.

I share this analogy because it represents the situation facing dealers in their used vehicle departments. There’s just not as much room between the ceiling (or prevailing retail prices) and the floor (the cost to acquire a vehicle) as there used to be.

Velocity dealers see this reality first hand. They know that the Price to Market ratios where many vehicles retailed in years past are lower today. They also know that this top-down pricing pressure makes it more difficult to consistently acquire vehicles at the Cost to Market benchmarks they previously achieved.

The reasons for the ceiling collapse in used cars shouldn’t be any surprise. Today, we face a much more efficient, fast-moving and transparent market. These market forces may not be colluding, but they are most certainly colliding, which puts unprecedented pressure on retail prices.

Some dealers point to the rising cost of used vehicles, particularly those they acquire at auctions, as a primary cause of ever-smaller front-end margins.

The observation is fair. But it misses the fact that the rising cost of vehicles wouldn’t be a problem if retail prices rose accordingly.

Unfortunately, that’s not the situation we face. Just because you spent $15,000 to acquire a vehicle doesn’t automatically mean it’ll retail for $17,000 or better. In today’s market, chances are better than good that the $15,000 unit will require a retail asking price around $16,000 if you expect it to sell in a timely manner.

The good news is that when dealers understand that margin compression is like a collapsing ceiling, they can take steps to mitigate its harmful effects on their used vehicle performance and profitability.

I typically recommend three operational fixes for the ceiling collapse problem:

1. Focus on investment quality. To use the house analogy, this strategic emphasis is like assessing the strength of each vehicle’s retail ceiling before you acquire the car.

For example, if you’ve got vehicle with sufficiently low Market Days Supply and Cost to Market ratios, you probably have a vehicle that’ll stand tall in the market for a longer period of time.

Conversely, if a vehicle has high Market Days Supply and Cost to Market ratios, you’ve got a unit that’s already weighed down by retail market pressures. By definition, it’s a less-sturdy car that represents an investment return that’ll sag more, the longer you own it.

2. Price to maximize your return. Stock investors should know the price point at which they will either make or lose money on an investment, before they choose to invest.

In today’s market, dealers should similarly align their pricing strategies to the investment outcomes each vehicle represents. If it’s a high-, middle- or low-gross unit from Day 1, your pricing should reflect this time-sensitive reality.

This approach is akin to accepting the fact that, in a house with a collapsing ceiling, there are some spots where you can stand, and others where it might be difficult to sit, or even crawl.

3. Fix your floor. Some dealers have gone too far in trying to lower the floor, or Cost to Market, in their used vehicle departments. They’ve pushed ever harder to acquire auction and trade-in vehicles with lower Cost to Market ratios than they targeted in the past.

On the surface, this approach makes financial sense. Who wouldn’t want to do all they can to increase the space between the retail ceiling and acquisition floor, and make more money?

But it’s a problematic practice, particularly if applied in a one-size-fits-all fashion. That’s when appraisers and buyers miss or overlook vehicles that would be perfectly good retail units except for the less-than-favorable (and often arbitrarily set) Cost to Market ratios.

The best-performing Velocity dealers recognize that while Cost to Market matters on every used vehicle, today’s margin-compressed market requires more flexibility.

Just like baseball, the dealers know that you can score runs without hitting homers every time you’re up to bat.